Kraft asks high court to rule on Iowa tax; case could influence state taxes nationwide.

WASHINGTON -- In a case that could have national ramifications, the Supreme Court is being asked to decide whether Iowa's corporate tax unfairly burdens U.S. firms that have foreign subsidiaries.

The case, Kraft General Foods Inc. v. Iowa Department of Revenue and Finance, tests whether the tax violates the Constitution's foreign commerce clause -- a provision giving Congress sole power to regulate foreign commerce. The provision is understood to ban state taxes that discriminate against firms that also do business in other countries.

Nine states have tax policies like Iowa's, and large corporations fear most other states will adopt similar systems unless the court overturns the tax. The court is expected to announce in early October whether it will hear arguments in the case.

"When you look at the financial conditions states are in, they have to do something to increase revenues," said Amy Eisenstadt, tax counsel at the Committee on State Taxation of the Council of State Chambers of Commerce.

"And it's easier to increase revenues by expanding the tax base by including out-of-state corporations that don't vote than it is to increase the tax rate on those who do," said Ms. Eisenstadt, whose group filed a friend-of-the-court brief on behalf of Kraft.

Kraft, which makes processed cheese and a host of other products, contends that Iowa's corporate tax discriminates against firms with foreign subsidiaries. The firm claims the state imposes a higher tax on corporations receiving $100,000 in dividends from foreign subsidiaries than it does on similarly situated corporations receiving $100,000 in dividends from domestic subsidiaries.

Iowa claims its tax does not favor local business at the expense of foreign commerce, and in any event, its treatment of dividends is merely a by-product of its decision to use federal taxable income as the starting point for computing net income taxable by the state.

"Use of the federal income figure results in benefits to taxpayers and the state," Iowa officials say in the state's brief urging the high court not to review the issue. "Therefore, the Iowa tax treatment of dividends is justified by a valid factor unrelated to economic protectionism."

In analyzing whether a state tax violates the commerce clause, the Supreme Court generally utilizes a four-prong test it developed in a 1977 case, Complete Auto Transit Inc. v. Brady.

Under that test, the court looks at: whether the tax is applied to an activity with a substantial nexus with the taxing state; whether it is fairly apportioned; whether it discriminates against interstate commerce; and whether it is related to the services provided by the state. When the case involves a foreign commerce clause challenge, the court also examines whether there is a risk of multiple taxation and whether the tax thwarts the ability of the federal government to conduct foreign policy.

The Kraft case arose in 1981, when the firm paid state taxes without including foreign subsidiary dividends in its calculations. Iowa's revenue department assessed additional taxes against the firm, claiming Kraft should have included foreign subsidiary dividends in its state tax base.

A state district court and the state supreme court both ruled against Kraft. The Iowa Supreme Court ruled the statute is constitutional because it does not benefit state businesses at the expense of foreign businesses.

In its petition for review by the U.S. Supreme Court, Kraft contends the Iowa high court should have examined whether the tax generally favors domestic commerce, rather than intrastate commerce.

Lawyers familiar with the case said Kraft's petition presents the Supreme Court with a novel question to settle. But most said the dispute is unlikely to be granted review. The court's schedule allows it to hear arguments only in about 140 cases of the roughly 5,000 presented to it during a term. Consequently, few state tax cases are argued before the court.

But Kraft could get a second chance. It is preparing an appeal to the Rhode Island Supreme Court in a case challenging that state's tax system, which is similar to Iowa's.

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